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David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures. Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

Nothing big here, but the swap curve briefly inverted twos to tens a few minutes ago. There is no reason to panic here; I’m just pointing out something that is highly unusual in the bond market. Having successfully traded bonds 2001-2003, I can say that strangeness tends to beget more strangeness. If this inversion gets larger and persists, I will have a post on the topic, but for now, this is just a curiosity.

Position: none, but the swap market affects us all in a wide number of quiet ways…

I did not expect the inversion in the Treasury curve to get so deep so quickly. At present, the Treasury curve is inverted 15 basis points from twos to tens. Does this mean the market is falling apart? No, only the economics of spread-based lenders.

Whoever taught me (way back when) that the swap curve can’t invert deserves a few whips with a wet noodle. It’s small, but swaps are inverted two basis points twos to tens. What will I see next? Inverted corporate curves for BBB bonds? I can’t imagine what that would imply for the economy. It would deepen my feeling that we are in uncharted waters in a low nominal world.

On the CPI, it is an advantage for TIPS buyers that the bond market focuses on the core CPI, when TIPS buyers get paid off of the unadjusted CPI. It allows us to get more yield off of our TIPS.

Inflation is higher than the core CPI indicates for a wide number of reasons, but the simplest one is that they exclude food and energy, whose prices have risen at faster than everything else for the past 10-20 years.

Eventually the long end of the Treasury curve will react badly when market players revise their long run inflation expectations, which in my opinion are too low. But for now, international flows dominate because US yields are higher than those in most other countries, and pension fund flows dominate because of a need to fund long liabilities. Until those factors quit, we will continue to live in a weird bond market, with uncertain implications for GDP and the equity markets as a whole.

This doesn’t make me change any of my strategies yet, but it does leave me uneasy.

Position: long long-dated TIPS, bank floating rate loan funds

Back then the yield craze was upon us, and credit risk forgotten. The swap curve was theoretically never supposed to invert on a yield basis. That was then, this is now. A new yield craze is upon us, where credit risk is omnipresent, even in securities of the highest quality. It reads, “I don’t care about the yield, just give me guarantees for a long time, and keep me safe.

What bond deals are getting done for investment grade names are getting done at amazing spread levels. (Baker Hughes, Pepsi — in 2002, spread levels for single-A names never got this wide, though some cyclical BBBs got that wide.)

The grab for safety is relentless, and the efforts of our Government are small relative to the size of the economy. The yields of the investment grade bond market are a truer measure of the troubles, because no one is fiddling with it yet. Even so, the fiddling may not turn even the manipulated markets around.

PS — As a final note, a kind word for the CDS market — their netting procedures work admirably, as pointed out by Alea (numerous times), and Derivative Dribble (a valiant start for a new blog). Here’s a wild thought: we need the same thing on a broader and more complex scale, allocating the embedded losses in our financial system to their rightful recipients, wiping out common, preferred equity, and subordinated debt as needed, and forcing the conversion of debt claims to equity, delevering the system in a colossal way.

CDS netting does that in a flash for synthetic debt exposures, but how do you do it for a wide number of assets at once? I’m not sure it can be done. My question is this: do the present actions of policymakers genuinely help, as they shift debts from private to public hands, or do they merely delay the inevitable? I hope the former, but I think it is the latter.

Full disclosure: long PEP

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About David Merkel

David J. Merkel, CFA, FSA, is a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited David to write for the site, and write he does — on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, and more. His specialty is looking at the interlinkages in the markets in order to understand individual markets better.
David is also presently a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also manages the internal profit sharing and charitable endowment monies of the firm.
Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
His background as a life actuary has given David a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that David will deal with in this blog.
Merkel holds bachelor’s and master’s degrees from Johns Hopkins University. In his spare time, he takes care of his eight children with his wonderful wife Ruth. View all posts by David Merkel →